As The Yahoo-Microsoft Search Alliance Falls Short, Could A Yahoo-Google Deal Emerge?

Once again, Yahoo is earning so little under its search deal with Microsoft that Microsoft is having to make up the difference due to a revenue guarantee. If the performance doesn’t improve, Yahoo might go looking for a new partner, which could include Google.

Let’s explore how the deal has continued to falter, quarter-after-quarter, and how the seemingly inevitable failure might lead Yahoo back to one-time partner Google.

The RPS Gap

During its earnings call this week, Yahoo chief financial officer Tim Morse said there continues to be a gap between the expected revenue earned per search and what Yahoo hoped its deal with Microsoft would produce.

I listened to the call live, and here’s what Morse said, as captured in the transcript from Seeking Alpha:

Unfortunately, similar to last quarter, we’re unable to report progress by Microsoft on closing the gap in marketplace RPS. The Search Alliance marketplace RPS continues to be below our goal and, therefore, we are still benefiting from the RPS guarantee from Microsoft. Both companies continue to work hard to materially improve the performance, and we plan to provide an update on our joint efforts at our next earnings call.

RPS stands for gross “revenue per search,” and according to the original agreement between Yahoo and Microsoft, the deal is supposed to be earning Yahoo an agreed RPS. If not, Microsoft has to make up the difference.

The agreed RPS has never been reached since the deal began. This became a big issue last year, when Yahoo got louder about blaming Microsoft for the deal not producing the anticipated revenues (see The Yahoo Search Revenue Disaster).

Microsoft is on-the-hook to pay a guaranteed minimum amount. Those guarantees were set to expire on March 31 of this year, but in October 2011, Yahoo announced that Microsoft had agreed to continue paying guaranteed amounts through March 31 of next year, for search activity happening in the US and Canada.

Trying To Earn What Google Does For Ads

What was RPS supposed to be for the past quarter and what was it actually? How much was paid by the guarantee for the past quarter in a dollar amount? Since RPS was originally based off the previous 12 months of earnings, was it lowered when it was renegotiated?

Those were some of the questions I sent to Yahoo, as well as a request to talk more generally about the deal. I wanted to make sure I wasn’t overlooking something when dealing with these complicated financial figures.

Yahoo sure wanted to talk to me last year, to help me understand things from its perspective after I tore into its poor earnings under the deal. Given this, I was fairly optimistic of a helpful run-through of Yahoo’s latest figures. Instead, all I got back was: “We don’t provide the RPS break out.”

Okey-dokey. I turned to Mark Mahaney, managing director and internet analyst for Citi Research. I’ve known Mahaney for years and always find his reports on the financials of various internet players interesting. Are there RPS figures out there? He told me:

I’ve never seen great numbers. My guess is that the RPS gap is on the order of 50 percent. In other words, Yahoo & Microsoft’s RPS is 50% less than Google. So if Google is generating $0.35 in RPS, then Yahoo & Microsoft are more like $0.18. But these are just guesses.

Here’s some more background. The deal has provisions that say RPS should be approach what Google generates, which I’ll get back to at the end of this story. That means all this talk about an “RPS gap” is about how ads that Yahoo gets from Microsoft and shows in Yahoo’s search results aren’t generating the same amounts that similar ads earn when they run on Google.

Bottom Line: Deal Isn’t Working As Planned

That leads to the big takeaway. Even without exact numbers, the deal clearly isn’t going the way that Yahoo expected. Each quarter, Yahoo has to awkwardly address how the gap remains. Going through all the earnings call transcripts, it’s painful reading. Grab a tissue.

This is from the first quarter that Yahoo began carrying Microsoft ads, the Q4 2010 earnings call:

As we enter 2011, the marketplace is not producing the click yield and RPS we had hoped, and it’s going to take continued focus over the next two quarters to get to the financial model we established for the Alliance.

From the beginning, the deal failed to meet expectations. Yahoo’s response? Give it two more quarters! But then in the following quarter, during the Q1 2011 earnings call, there was more disappointment:

On the downside, however, adCenter isn’t yet producing the RPS we hoped for and are confident as possible. Advertisers are seeing strong ROI, but technical limitations in the current adCenter platform mean the click volumes just isn’t there yet. We had expected RPS to be neutral by midyear, it’s now evident that it will take Microsoft longer to achieve that goal. We expect that to happen by year-end.

Not only has the deal not worked as planned for two quarters in a row, but now Yahoo warns that disappointments would continue to happen through the end of 2011. They sure did. From the Q2 2011 call:

We’re behind in the RPS benefits from the combined marketplace, but our revenue is protected by the Microsoft RPS guarantee…. we believe we’re on track to achieve RPS parity by the end of the year.

The First Rule Of RPS Club Is Never Give The RPS Figure

By the way, Yahoo has been talking about how important this RPS figure is for three quarters now to investors, yet it still has failed to say what exactly the figure is.

It’s the benchmark that can’t be named, which causes former Yahoo CEO Carol Bartz to do this convoluted dance during the Q2 2011 call to explain that whatever the gap is, it’s been closed by 20% from where it was in April:

By the end of Q2, we’ve closed approximately 1/5 of the RPS gap that we measured in April before the new platform initiatives were launched. Let’s be clear about what that means. That does not mean that RPS was up 20%. It means that 1/5 of the RPS gap that existed in April has already been closed.

It’s crazy. It’s also followed by bad news the following quarter. During the Q3 2011 call, it’s so clear that the gap isn’t going to be closed that Yahoo announces it has managed to get an extention of the Microsoft guarantees:

In order to create more financial certainty, Microsoft and Yahoo! recently agreed to extend the RPS guarantee in the U.S. and Canada through March 2013. We will continue our joint work with Microsoft to close the remaining gap as quickly as possible, and we’re obviously working to do so before that time frame. Both companies remain fully committed to the success of our Search Alliance and the RPS guarantee extension represents an important sign of that commitment.

But there’s some supposedly good news. Yahoo’s managed to close the gap a bit more. As Morse says:

Once again, operational RPS in the U.S. grew sequentially as both Microsoft and Yahoo! completed initiatives to close the gap. At the end of 3Q, we had closed nearly 30% of the RPS gap that existed in April.

Sounds good, right? Big number, 30 percent. But remember, Yahoo had previously said the gap had been closed by 20 percent. After a full quarter of everyone working their hearts out at Yahoo and Microsoft, they only managed a further 10% improvement.

That’s also an improvement off whatever the gap was in April 2011. For all we know, the gap between what Google was earning for ads and what Yahoo was earning was 90% at that time, so even a 30% closure would still leave Yahoo earning less than half what Google was getting for an ad.

The Unreachable Goal…

By the end of the year, it’s official. The RPS gap remains. Heck, Yahoo couldn’t even get a further 10% improvement over the previous quarter. From the Q4 2011 earnings call, Morse said:

Although our U.S. results still benefited from the Search Alliance RPS guarantee, operational RPS in the U.S. improved by mid- to high-single digits compared to both prior quarter and prior year.

I hate math, but let’s do some. We have a mystery gap in April that got reduced by 20% after a quarter, then a further 10% after a second quarter of work. Now after a third quarter of work, it’s been closed from what sounds like 5 to 9 percent. It’s like one of those approaching infinity exercises. Each quarter that passes, the gap is only closed by half as much as the quarter before. You’ll never get there!

Despite this, Morse is full of praise! Again, it’s crazy. He says this:

In fourth quarter, Microsoft implemented several improvements that generated greater clicks for advertisers, especially on critical dates like Black Friday and Cyber Monday. Yahoo!’s sales teams also executed well on account optimization, delivering strong results for many key Search advertisers. In fact, last quarter, we saw some of the best execution to date from the alliance, from algo performance to technology enhancements to sales optimization….

The “improvement” rate in closing the gap is half what it was the previous quarter, twice as bad as what it was two quarters before, and yet this was some of the “best execution” from the alliance? Either I’m completely missing something or Yahoo’s succeeding in sounding positive because it doesn’t have any concrete benchmarks to be held to.

As an aside, reading that Microsoft somehow did something that really helped on Black Friday and Cyber Monday to boost ads, I immediately wondered if all those Black Friday and Cyber Monday sites that mysteriously disappeared from Microsoft’s search results — which Yahoo also uses — factored in some way.

Stays Unreachable

The following quarter, from the Q1 2012 earnings call, there’s no closure of the gap at all:

This quarter, we’re not able to report significant progress by Microsoft on their effort to close the gap in marketplace RPS, but we are actively working with them to improve those results, as well as to achieve more consistent progress in closing the RPS gap in the future.

Again the math. The gap was reduced by 20%, then by another 10%, then by 5-9% and now by 0%. Yahoo’s never getting there, not with this alliance. That should be pretty clear at this point. Yet when pressed, Morse says he believes the gap will get closed by March 31, 2013, when the extended guarantee ends:

The second question you had was on RPS gap. So we’re working hard with Microsoft, working hard on our own initiatives and Microsoft certainly working hard on the platform for our marketplace RPS. And it didn’t make as much progress, frankly, as we wanted to or envisioned for first quarter, and that is concerning. But we’re covered for another year here of the RPS guarantee, and I still firmly believe we’ll get there by the time that the RPS guarantee runs out. So it’s an important thing for both of us, and they’re certainly working hard and we’re helping right along with them.

That brings things back to the quote I had at the beginning of this article, from the most recent Q2 2012 earnings call: “We’re unable to report progress by Microsoft on closing the gap in marketplace RPS.”

Never Gonna Close The Gap: The Bulletpoint Version

For those who need an update, the improvement track record, quarter-by-quarter over the past year, now looks like this:

April 2011: Unknown RPS gap used as benchmark

July 2011: Gap reduced 20%

October 2011: Gap reduced a further 10%

January 2012: Gap reduced 5% to 9%

April 2012: Gap reduced 0%

July 2012: Gap reduced 0%

Whatever the gap was in April 2011, Yahoo has only nine months to close the remaining 60% before the revenue guarantees run out. Even if Yahoo makes it, for all we know, there will still be some type of a gap. I think it’s also fair to assume that because Yahoo consistently refused to say what the gap it, it’s probably pretty bad.

Good News On Search Revenues, But….

This is the part where I should start writing about how Google might come to the rescue, but I’m saving that for dessert. First, I wanted to share some good news after all that sad, sad recounting about how the RPS gap may never close.

Look at this chart (you can click to enlarge it):

That’s the “search revenue ex-TAC” that Yahoo has earned each quarter from search ads, in millions of dollars. TAC stands for “traffic acquisition costs,” and ex-TAC means this is the net money that Yahoo retains from these ads after paying some fees to affiliates or partners. There’s been a slow but steady rise over the past year-and-a-half.

On the other hand, I’m fairly certain that these figures don’t reflect the 12% that Yahoo has to pay Microsoft for any ads that are coming from the deal with Microsoft. Factor that in, and the line, while rising, still would be below the $357 million low-point of Q1 2011.

Only Yahoo really knows for certain what the “net net” is. Somewhere in all that may be money that Microsoft paid it under the guarantee agreements, reducing that potential 12% reduction. It’s very difficult to figure out.

What’s not hard to figure out is that the partnership, delivering ads to Yahoo since Q4 2010, hasn’t massively improved the plunge Yahoo was seeing in net search revenue since Q1 2009. And now it’s time for dessert.

Yahoo’s “Out” & The Google Factor

The US Department Of Justice warned that if Yahoo and Google went ahead with the search deal they wanted in 2008, it would take anti-trust action. You know, because that might do things like cause advertising rates to increase (as if Google has some type of set rate card).

It’s pretty clear that effectively forcing Yahoo into Microsoft’s arms didn’t change Google’s ad rates. If that were the case, Google wouldn’t have an RPS that Yahoo and Microsoft are diligently struggling to match.

If the deal had gone through, there’s also a pretty good argument that Yahoo could have been meeting or exceeding those RPS figures that the Search Alliance is failing to hit.

That’s speculation about the past. We’ll never know. But it leads to speculation about the future. The revenue guarantees will expire within a year, and it seem extremely unlikely that Yahoo will achieve the RPS set in the agreement. If not, Yahoo has the option to terminate the agreement. An “out” as Morse put it on the earnings call earlier this week:

And then finally, on the RPS guarantee, so we are covered under this guarantee until the end of first quarter next year. So we still have 9 months or so to go. Again, we’ll, as we get closer to that time, we’ll see where our GAAP looks to be. We’ll see what, well, Microsoft are going to be doing about it. And we’ll make sure that we’re transparent on that. The — in terms of ultimately the outs for the deals in the agreement that we’ve made public for a while now, I think it — well, I know, not I think. It is after 5 years, there was an RPS threshold versus the market leader that we must be at. And if we are not at that, then there is an out.

Five years into the agreement is February 23, 2015, by the way. But no need to mark that on your calendar. March 31, 2013 is the better date to watch. That’s when the extended revenue guarantees end. When they do, Yahoo may be irked enough (or pressured enough) to terminate the agreement before the five year mark. After all, Yahoo may have that right.

Yahoo! may terminate the Search Agreement if the trailing 12-month average of the RPS in the United States (the “U.S. RPS”) of Yahoo! and Microsoft’s combined queries falls below a specified percentage of Google Inc.’s (“Google”) estimated RPS measured on a comparable basis or if the combined Yahoo! and Microsoft query market share in the United States falls below a specified percentage

Apparently, if Microsoft isn’t getting close enough to its ads earning what Google’s ads earn, Yahoo can walk away.

If Not Microsoft, Who Else But Google?

Of course, Yahoo can’t walk away without finding another partner, and it has a real shortage of choices. There’s no one left in the US with the proven ability to deliver search queries at the volume Yahoo would demand.

Ask.com? It’s largely outsourced to Google these days. Blekko? I’m sure it would love the job, but there would be a huge scaling-up challenge and, I’d say, much more work to do on the relevancy front. Maybe Yandex or Baidu could make a bid?

It won’t be Yahoo. Yahoo has lost too much key search talent and hasn’t kept its core search technology up-to-date. When it gave itself over to Microsoft, Yahoo really left itself without a “Plan B.”

The post also gets into the challenge of whether Yahoo would even be allowed to partner with Google. The Department of Justice objected before; it might again. But times also change. Yahoo’s weaker now, plus the Search Alliance clearly hasn’t been benefiting it as expected nor somehow magically reducing Google’s ad prices.

Search Alliances Has Been Very Good For Microsoft

The Search Alliance has been excellent for Microsoft, of course. Without Google as a possible bidder for Yahoo’s attentions, Microsoft was able to greatly reduce what it originally was going to pay. Sure, Microsoft originally wanted all of Yahoo. But still, when you’re the only bidder in town, you get a bargain.

By the way, the head of the DOJ’s anti-trust division when the ruling blocking a Yahoo-Google deal came down? That was Thomas Barnett. He’s now a partner with Covington & Burling, a legal firm that — wait for it — Microsoft uses on anti-trust issues.

That deal got Yahoo to willingly abandon its search technology and search ads platform, so that it could focus on, well, finding new CEOs. All that distraction, all that figuring out where Yahoo should go, and Microsoft’s Bing has been firmly focused on search, overtaking Yahoo’s search share in the US.

Still, Microsoft’s online operations lose hundreds of millions per quarter. We’ve even had a report that some Microsoft execs suggested selling Bing to Facebook. But turn again to the “Termination Provisions” of the Yahoo-Microsoft search deal:

Yahoo! may terminate if Microsoft attempts to exit the business of algorithmic search or search monetization, either by ceasing to offer the services or by selling or attempting to sell all or substantially all of either its algorithmic search services business or paid search services business to an unaffiliated third party

Hmm. Assuming Microsoft did off-load Bing, it’s not like that guarantees that Yahoo would come to the party.

Anyone For Yahoo Buys Bing? Apple Buys Yahoo?

That leads to another bit of fun speculation. What if new Yahoo CEO Marissa Mayer — who knows search pretty well — pitches that Microsoft should sell Bing to Yahoo? Or perhaps, Bing’s search talent and technology? What if Yahoo decides to reassume all the search technology and ad operations, promising that Microsoft can have its own search engine without all those pesky costs, just as Microsoft once promised Yahoo?

Wouldn’t that be fun to watch? What could beat that?

Well, how about Yahoo gets back its search engine, then Apple starts thinking it would like to have a search engine and portal services to better round-out its cloud offerings?

Personally, I think it’s far-fetched Microsoft will give up on Bing yet. My bet is that there’s going to be some seriously hard renegotiating between Yahoo and Microsoft, with Google used as a cattle prod for Yahoo to shock Microsoft with. I’m guessing Microsoft will double-down on the spending all around. But we’ll see.